Published: November 06, 2014
Companies in Western Europe and Central and Eastern Europe are more connected than ever. Many have supply chains that span multiple countries and sales and operations in both regions. As CEE companies move up the value chain and increasingly focus on services, connections between West and East will continue to evolve.
Twenty-five years ago, as Central and Eastern Europe (CEE) emerged from communism (and near economic collapse), an unprecedented opportunity emerged for companies in Western Europe and CEE to forge new connections. By setting up subsidiaries and joint ventures to produce and sell goods, and building relationships with new suppliers, companies have created a truly connected Europe.
For Western European firms, the opening up of CEE provided access to more than 100 million new consumers.
Today, the region’s shopping malls highlight the strength of the bond between Western Europe and CEE. Germany’s Metro Group and Schwarz Gruppe, which operates Lidl stores, are among the largest retailers while Germany’s T-Mobile and the UK’s Vodafone are leading players in mobile telecoms.
Western companies also spotted the potential benefits of relocating production to lower-cost countries, and exploiting cross-border supply chains. Now, Western Europe and CEE is connected through hundreds of intricate supply chains for multiple industries. The vast majority of CEE’s foreign direct investment is from Western Europe while one third or more of CEE countries’ top-15 trade partners in global value chains are from the euro area.
Integration between Western European and CEE has not just delivered benefits for Western Europe. Investment in CEE has dramatically increased: research and development as a percentage of CEE’s GDP has grown from almost nothing before 1990 to 0.43% from 2001-2012. More generally, Central and Eastern Europeans have benefited from improved skills, better employment prospects and higher incomes.
The establishment of supply chains has spurred the creation of new companies. Of the 700 automotive suppliers in Poland, half are domestically owned. These suppliers are part of an industry that is central to CEE’s prosperity. The auto sector has turnover of roughly €150 billion, and grew by 170% between 2009 and 2014: 44 manufacturers in CEE now produce over 3.5 million vehicles a year – and contribute an average of 10% to CEE countries’ GDP.
Access to foreign know-how to upgrade production facilities, as well as to international capital and global distribution channels, has enabled CEE companies to make new connections across Western Europe and worldwide. Ukrainian agribusiness Kernel, the world’s largest exporter of sunflower oil, now supplies an estimated 16% of the world’s traded sunflower oil, partly because of a series of innovative financings (involving ING) that have enabled it to grow rapidly. Polish cosmetics firm Inglot and Polish organisation KCR, which provides contract research services to pharmaceutical companies, are also expanding across Europe and the world.
The strength of the connections between companies in Western Europe and CEE companies is clear. But what drives those connections? Historically, one of the most important drivers has been the cost differential between the two regions. While wages in CEE have risen significantly in recent decades, they remain significantly cheaper than Western Europe.
Hourly wages in Bulgaria, Croatia, the Czech Republic, Hungary, Poland, Romania, Slovakia, and Slovenia are on average 75% less than in EU15 countries (the pre-2004 members of the EU) and are as much as 90% lower in Bulgaria and Romania. Consequently, businesses in Western Europe continue to seek new supply relationships or set up their own low-cost production facilities. Flat, or falling, wages in the post-crisis period (as well as devaluation of some currencies) have helped to further improve competitiveness and spurred new investment.
In May, specialist contract electronics manufacturer AWS expanded its operations in Slovakia. “Many of our customers are under pressure to regularly review pricing structures in order to remain competitive,” says Paul Deehan, AWS Group CEO. “We have been able to alleviate some of this pressure through offering low-cost manufacturing in Slovakia,” notes Deehan. The company says that costs at its Slovakia facility are now comparable with countries such as China and Malaysia. As a result, some customers are re-shoring work from South-East Asia to CEE.[[[PAGE]]]
While costs remain important, CEE companies recognise that they cannot compete solely on price – other countries, such as Vietnam or Bangladesh, for example, are always going to be able to undercut CEE. However, relatively higher prices are not necessarily a deterrent to greater supply chain integration between Western Europe and CEE. Instead, integration is increasingly being driven by CEE’s other advantages, such as location and quality, which are hard – if not impossible – for other countries to replicate.
Sourcing from CEE allows companies to capture a significant portion of the savings available in China while paying only a fraction of the penalty in lengthening supply chains
Sourcing from CEE allows companies to capture a significant portion of the savings available in China while paying only a fraction of the penalty in lengthening supply chains notes a report by Boston Consulting Group. Speed of delivery to Western Europe from CEE is measured in days rather than the weeks it takes by ship from China. In sectors that are time sensitive that is an advantage worth paying for. The report adds: “Furthermore, as almost all the goods manufactured in CEE arrive in Western Europe by truck or train, the risk of port congestion is avoided.”
One company that understands the importance of proximity to achieving a swift turnaround of stock is Zara, a brand owned by Spain’s Inditex, one of the biggest fashion success stories of the past decade. Zara produces 450 million items every year for its 1,770 stores in 86 countries from factories worldwide. While basic items, such as t-shirts, are ordered from Asia to keep costs low, Zara’s fast fashion items, modelled on catwalk trends, are made closer to its European retail market, including in Turkey. The company has invested in high-tech equipment and extra capacity to ensure it can rapidly produce items as demand changes.
The experience of the post-crisis period has reinforced the importance of flexibility and innovation to suppliers in CEE, further strengthening their integration with Western Europe. According to marketing and research agency IDC, CEE firms acknowledge that plants must be upgraded, supply chains better integrated, new business and sourcing models considered, and plant floor visibility improved. “IT investments play an essential role in all of these areas,” says the report. Consequently, IT investments by CEE manufacturers will be more than 21% higher in 2017 than in 2013 for five core countries (the Czech Republic, Hungary, Poland, Romania, and Slovakia), according to IDC.
More generally, CEE suppliers are increasingly recognising the importance of quality as a differentiator from lower cost producers in Asia. In 2009, when Lewiathan, Poland’s private employer’s confederation, surveyed small and medium enterprises, 60% of respondents said they were planning to compete on price and nothing else. In 2012, when the survey was conducted again, only 10.6% said they planned to compete on price, with nearly half saying they were focused on quality: they are moving up the value chain. A focus on quality also ties in with CEE’s advantage of its proximity to key markets in Western Europe, which are increasingly willing to pay extra for high quality goods.
Production of goods will continue to be an important driver of connections between companies in Western Europe and CEE for many years to come because of the reasons outlined above. However, connections between companies in the two regions are increasingly the result of outsourcing and offshoring (O&O) of IT, telecoms, administration, support and professional services.
Research by real estate services firm Colliers International in June showed that the volume of office space consumed by O&O companies in CEE grew a massive 80% from 2010 to 2013. “While there is evidence the sector is maturing, geographically, the footprint of the sector is still expanding,” says Damian Harrington, regional director of research for Colliers International, Eastern Europe. McKinsey estimates that CEE now employs nearly 300,000 people in O&O work.
O&O’s growth has been facilitated by a number of factors. At a basic level, most of CEE is in the same time zone as Western Europe, making communications and travel straightforward, English is widely spoken, and there is a similar business culture to Western Europe. Most importantly, CEE workers have the necessary skills. About 22% of CEE’s labour force has tertiary education and 29% of workers aged 25 to 34 have college degrees, matching the Western European rate for all workers, according to McKinsey.
O&O’s role in bringing Western Europe and CEE together is likely to increase in the coming years. Initially, O&O businesses concentrated in locations such as Budapest, Prague, Krakow, Warsaw and Bratislava because of the depth of skills and experience available. Competition for labour has now increased costs in these locations. Cost savings and efficiency remain important and there has been rapid growth in new O&O locations such as Belgrade, Kyiv and Riga because they are cheaper. However, Colliers says established O&O centres are moving up the value chain and providing higher value-add functions.
CEE is also becoming an increasingly important centre for logistics. Last year, Amazon.com hired 6,000 permanent employees for three new logistics centres, IBM opened a service centre and Procter & Gamble established a European planning and logistics hub in Poland.[[[PAGE]]]
The relationship between Western Europe and CEE companies is dynamic and has changed significantly in the past 25 years. CEE’s attractiveness as a location for manufacturing was initially based on its low costs. However, subsequent integration has also been driven by the increased importance of proximity to Western Europe and improvements in quality of CEE’s production.
The experience of the financial crisis highlighted the importance of safeguarding supply chains. Supply chain finance programmes, which provide low cost finance to suppliers, are increasingly common as a result and have further deepened integration between the two regions. Meanwhile, CEE has also emerged as a location for services.
The nature of connections between Western Europe and CEE will continue to evolve and will continue to deliver benefits for both regions. New connections may develop from industries that have yet to emerge. At a more prosaic level, increased supply chain and sales and operations integration between companies in Western Europe and CEE could mean that the regions will be seen as one.
Already, for a growing number of companies, it is becoming more efficient to manage Western Europe and CEE as a single region. Electronics manufacturer AWS does not differentiate between Western Europe and CEE (or indeed the rest of the world) in terms of business development: its group sales director, whose responsibilities include the whole of mainland Europe, is based in Bratislava. In the future, such arrangements are likely to become commonplace.
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